Issue #76, 15 December 2010
In this issue:
What happens when a pension
fund makes losses for tax
purposes? Can they be carried
forward (and used in the future)
or are they lost? And does it
really matter – since pension
funds don’t pay tax anyway?
Introduction
Not surprisingly, many
superannuation funds have made
losses on their investments in
recent years.
Where these are realised (ie, the
assets are actually sold), many
funds will have a capital loss.
Other funds make losses simply
because they are able to claim tax
deductions that exceed their
income – we generally refer to
these as income losses.
In this edition of Heffron Super
News we highlight some
interesting outcomes of the tax
rules governing losses in self
managed superannuation funds.
In particular, we explore some
traps that arise in funds that are
paying pensions.
either advisers or accountants –
often at great benefit to the client.
Perhaps the first important
principle to establish is that capital
and income losses are generally
treated differently for tax purposes
and the same applies in
superannuation funds.
Income losses are normally
carried forward too. A key
difference, however, is that
income losses can be offset
against any future income,
regardless of whether or not that
income comes from a capital gain,
concessional contributions,
dividends, rent etc.
Capital losses
But what about pension funds?
Regardless of the tax entity,
capital losses can generally only
be offset against capital gains. In
other words, a superannuation
fund cannot escape paying tax on
its concessional contributions or
interest income just because it
has a made a capital loss. The
loss will only reduce or remove
the tax it pays on capital gains.
So how does this work in a
vehicle which isn’t paying much
(or even any) tax at all when it
makes the loss – such as a
superannuation fund paying
pensions? Like most
superannuation questions, the
answer starts with “it depends”.
The principles
When the losses made in any
particular year exceed the capital
gains, the taxpayer might have a
capital loss to carry forward.
Normally, the taxpayer just keeps
a record of the amount of the loss
and uses it progressively over
time as it realises capital gains in
the future.
Our tips to avoid them are simple
and very easy to implement for
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Income losses
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Two approaches for
capital losses
The treatment of capital losses in
superannuation funds (including
self managed superannuation
funds) paying pensions depends
on whether the fund is
“segregated” or “unsegregated”.
SMSF practitioners will be familiar
with these terms – generally
speaking a “segregated” fund is a
fund where specific assets have
been set aside to underpin one or
more pensions while an
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Issue #76, 15 December 2010
“unsegregated” fund is one where
there are both pension and nonpension balances and the fund’s
assets are shared or pooled
between them.
In a “segregated” fund, once a
pension starts1 capital gains and
losses realised on the assets set
aside for the pension(s) are
simply ignored [s 118-320 ITAA
1997]. They don’t even appear
on the fund’s tax return. (Note,
that gains and losses on any other
assets that the fund has – for
example, assets set aside to
underpin accumulation balances –
are still taxed in the usual way, it
is only the gains and losses on
pension assets that are ignored.)
While that means that no tax is
paid on the capital gains, it also
means that any losses realised on
the pension assets once the
pension starts cannot be carried
forward. In effect, they are simply
lost. Whether or not this is a
problem is discussed further
below.
In an “unsegregated” fund, both
the gains and losses are added
up and the losses are offset
against the gains.
Where applicable (ie, where a
gain has arisen on an asset that
was held for more than 12
months), a 1/3rd discount is
applied to the net amount in the
usual way. The end result (if it’s
positive) is included in the Fund’s
assessable income and ultimately
reduced to reflect the fund’s
“exempt current pension income”
(ie, if the fund is 40% in pension
phase, 40% of this end amount
will not be taxed).
Where the net amount is negative
– ie, the fund has a capital loss,
the full amount of the capital
loss is carried forward.
Importantly this capital loss can
also be carried forward
indefinitely.
A practical example
To compare the two methods,
let’s assume we have two funds
that are almost identical.
Both have earned $50,000 in
capital gains (some eligible for the
discount and some not) but have
also realised capital losses of
$80,000.
They have no other investment
income, there are no expenses
(purely for illustrative purposes)
and concessional contributions
were made to each fund.
The difference between the two
funds is:
1
Note that any capital losses realised
before the pension commenced can be
carried forward to a later income year [s
102-15(3) ITAA 1997].
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•
Fund A is segregated – the
whole fund was in pension
phase until right at the end of
the year when the
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concessional contributions
were received. They were
held in a separate bank
account and hence the fund
remained “segregated”
throughout the year;
•
Fund B is unsegregated –
almost all of it is in pension
phase but a tiny amount was
still accumulating during the
year (and of course the
contributions were received
late in the year and added to
this accumulation balance). In
fact, this amount is so small
that the actuarial certificate
obtained by the Fund’s
accountants shows that the
Fund’s investment income is
99% tax exempt.
Both funds have obviously made
a capital loss ($30,000) but only
Fund B can carry that loss forward
to the next year.
Fund A would only be able to
carry a capital loss forward if it
also had other (non pension)
assets and these had generated
losses too – those losses alone
(excluding the $30,000 loss on
the segregated assets) could be
carried forward.
And the next year?
Let’s say that the following year,
both Funds generate $50,000 in
capital gains (and no other
investment income is earned nor
expenses incurred). Neither Fund
is entitled to any CGT discount
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Issue #76, 15 December 2010
because the assets sold were
held for less than 12 months.
In Fund A, those gains were
achieved partly on the segregated
pension assets ($40,000) and
partly on some accumulation
assets (new non-concessional
contributions) - $10,000.
In Fund B, the actuarial certificate
% for exempt income is now 80%
(this fund has also received new
non-concessional contributions
and the accumulation balance has
therefore grown).
Again, the funds are therefore
almost identical, but Fund A is
segregated while Fund B is not.
Tax in Fund A will be simply
$1,500 (15% x $10,000 gains
made on the accumulation
assets).
In Fund B, however, the process
will be different.
Firstly, this year’s capital gains
($50,000) will be reduced by the
carried forward capital losses
($30,000), leaving a net $20,000.
As the actuarial certificate
indicates that 80% of the Fund’s
investment income is tax exempt,
only 20% of this amount ($4,000)
will be subject to tax.
Tax of only $600 will be paid.
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What about losses
realised before the
pension started?
Starting a pension (either on a
segregated or unsegregated
basis) does not mean that capital
losses made in the past (and
carried forward to date) are
written off.
Rather, these “pre-pension”
losses are carried forward but
again, there are significant
differences in outcome between
segregated and unsegregated
funds.
Normally, carried forward losses
are “used up” by capital gains in
subsequent years.
However, bear in mind that capital
gains and losses on segregated
pension assets are completely
disregarded.
This means that a fund which
(say) realises a very large loss
and then (the following year)
converts entirely to pension phase
will effectively freeze that capital
loss and carry it forward
indefinitely – the gains on the
segregated assets in future years
will not affect it [s 102-15(3) ITAA
1997].
Alternatively, a fund may be
segregated by virtue of the fact
that the trustee maintains
separate pools of assets for
accumulation and pension
liabilities.
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In this case, the gains on the
“accumulation” side of the
portfolio will use up the carried
forward losses but not the gains
on the “pension” side.
In contrast, “pre-pension” carried
forward losses might well be used
up far more quickly in an
unsegregated fund.
Following the same process as
outlined earlier for Fund B – all of
the fund’s gains are offset against
the capital losses. In effect, this
may well see the fund “using up”
some of its carried forward losses
on capital gains that were
substantially tax free anyway.
Let’s consider two new funds – C
and D which both have carried
forward losses of $20,000 before
they start any pensions. They are
almost identical except that:
•
Fund C converts entirely to
pension phase (and is
therefore segregated). During
the year, it achieves capital
gains of $30,000; but
•
Fund D leaves a very small
amount in accumulation
phase. In fact, the amount is
so small that the fund’s
actuarial % is 100% but it is
nonetheless not segregated.
It too realised capital gains of
$30,000.
At the end of the first year of
providing pensions, neither fund
has actually paid any tax.
However:
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Issue #76, 15 December 2010
•
•
Fund C still has carried
forward capital losses of
$20,000 (the $30,000 gains
are completely ignored and do
not “use up” the carried
forward loss); but
Fund D no longer has any
carried forward capital losses
– the full $30,000 gain is
effectively offset against the
carried forward loss amount.
Having your cake…
In the ideal world, then, funds
would be unsegregated (or not
even providing pensions at all) at
the time any substantial capital
losses were realised.
This enables the losses to be
carried forward.
There are two main barriers to
ensuring that a fund is
unsegregated in a year when a
capital loss is realised.
Firstly, some funds choose to
segregate their assets for a range
of valid reasons which extend well
beyond issues such as carrying
forward capital losses. (We have
discussed some of these below.)
Secondly, however, is tax
avoidance. When the current
rules on tax exemptions for
pension funds were first
introduced (at the time – via
changes to the Income Tax
Assessment Act 1936), the
Explanatory Memorandum to the
relevant Bill indicated that
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routinely swapping assets
between the “pension” and
“accumulation” portfolios in a
segregated fund ran the risk of
exposing the trustee to Part IVA of
that Act (the provisions dealing
with tax avoidance).
The same is potentially true of an
arrangement under which a fund
“segregates” one year but not the
next – and regularly changes
between the two. (Remember
also that segregation is only
legally effective if done in advance
– it cannot be retrospectively
applied.)
Hence we would not advocate
regular changes to the basket of
assets that have been specifically
identified as pension assets in a
genuinely segregated fund.
However, one “segregation”
scenario that often arises almost
by accident in practice is where a
fund is considered segregated
simply because it is entirely in
pension phase. While there may
be several members / balances
and the assets are not segregated
between them, the fact that all
members are entirely in pension
phase means that the fund is
considered segregated for tax
purposes.
normal bank account (rather than
creating a separate account to
maintain the segregation).
This is essentially the position
applicable to Fund B – recall that
it was almost entirely in pension
phase but for a small
accumulation balance held
throughout the year. That
balance could be so small that the
fund’s investment income is still
virtually 100% tax exempt (in
accordance with the actuarial
certificate) but it nonetheless
means that the Fund is
“unsegregated”.
… And eating it
In the ideal world, funds would be
segregated in the years after a
capital loss had been carried
forward (because this ensures
the losses are used up as slowly
as possible).
Remember, however, that a return
to complete segregation could be
as simple as paying out a small
accumulation balance as a lump
sum early in the year or
converting it to a pension. At that
point, the gains achieved within
the fund no longer act to reduce
the losses carried forward.
This is relatively easy to change
without fundamentally altering the
way the fund operates – simply
roll back a small amount to
“accumulation” phase OR accept
new contributions into the fund’s
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Issue #76, 15 December 2010
accumulation phase (and
these generate capital gains);
optimising the carried forward
losses. For example:
•
The pensioner decides to “roll
back” some or all of the
pension account to
accumulation phase and more
of the fund’s investment
income becomes “taxable”; or
•
•
The recommendation of the
Henry Review to tax pension
funds at 7.5% (rather than
nil%) is introduced.
A large gain is expected on
one particular asset and the
fund is only partly in pension
phase – segregation will
clearly help to minimise the
tax on that gain over the long
term, even if it does mean that
smaller capital losses incurred
along the way cannot be
carried forward;
•
Two members (one in pension
phase and one not) may have
different investment strategies.
Does it actually matter?
It might not.
The reason the carried forward
capital losses were useful in, say,
our Fund B example above was
that the fund had taxable gains
which arose in a future year.
If instead, Fund B had:
•
•
•
Converted the accumulation
balance to pension phase at
the end of the year (from
which point all of the fund’s
assets would be “segregated”;
From that point, remained
entirely in pension phase; and
the member had gradually
drawn out the entire balance
and no capital gains had been
made on death
there would have been no value
at all in being able to carry
forward these losses.
However, there are a range of
circumstances under which
pension funds revert to paying
tax. For example:
•
•
The pensioner dies (leaving
no reversionary pensioner)
and the balance is paid out as
a lump sum to his or her
dependants or estate. At that
point, substantial capital gains
may well be realised;
As was the case in the
examples above, the fund
receives additional
contributions which remain in
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Under these circumstances some
carried forward capital losses
would be very handy!
What the discussion above
highlights is that there are some
rules of thumb. All other things
being equal, maximum benefit is
derived from capital losses (ie,
they can be carried forward most
effectively) if:
•
•
The fund is not segregated
when the losses are actually
realised (as this allows the
fund to carry the loss forward
in the first place); but
The fund is segregated
afterwards (as this minimises
the rate at which the loss is
used up).
This could well override the points
discussed here. Funds will not
necessarily have their segregation
policy driven by the need to
maximise their use of carried
forward losses but all other things
being equal, it would certainly be
a consideration.
What about Income
losses?
Unlike the treatment of capital
losses, the treatment of income
losses between the two types of
pension fund (segregated and
unsegregated) is exactly the
same.
An aside - pooling v
segregating
In both cases, income losses can
be carried forward.
Funds that are genuinely
segregated may be operating that
way for reasons that are
considered more important than
Unfortunately, however, their
value is diminished by the fact
that they are effectively “used up”
by the Fund’s “exempt current
pension income” (ie the part of the
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Issue #76, 15 December 2010
fund’s investment income
(including capital gains) that is not
taxed because it is providing
pensions).
In other words, the fund uses up
its carried forward income losses
just as quickly as it would if it was
not in pension phase.
Conclusion
Many pension funds will never
pay material amounts of tax (on
capital gains or other income)
again.
However, there are obviously
some circumstances where tax reemerges – either due to
unforseen circumstances (death
or legislative change) or because
the fund is not entirely in pension
phase.
For that reason, funds realising
very large capital losses may like
to consider ensuring they remain
“unsegregated” so that they can
carry forward that loss.
Afterall, the next most useful
expression in superannuation
work (after “It depends”) is “you
just never know”.
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On a separate note..
Business real property receives a
range of concessions in
superannuation law – in particular,
it can be leased to a related party
without being classified as an inhouse asset.
However, it is worth noting that to
receive this concession, the
business real property must be
“subject to a lease or to a lease
arrangement enforceable by legal
proceedings” [SIS s71(1)(g)].
In many contexts, a contract can
be entered into verbally and be
legally binding. However,
arrangements relating to property
must generally be in writing.
In NSW for example,
Conveyancing Act 1919 requires
that instruments which create
rights in relation to land must be in
writing. In fact, the Real Property
Act 1900 (covering most land that
is business real property) requires
that leases which operate for
more than three years must not
only be in writing but must also be
registered.
On that basis, we would generally
recommend that any business
real property which is leased to a
related party is covered by a
written lease agreement (albeit
that lease agreement may well be
a rolling 1 year agreement to
avoid the need for registration!)
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Disclaimer
Heffron Super News is an electronic newsflash
which highlights important events in the
superannuation arena. If you are not already on
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While Heffron believes that the information
contained herein is reliable, no warranty is given
to the accuracy and persons who rely on it do
so at their own risk. This publication is
intended to provide background information only
and does not purport to make any
recommendation upon which you may
reasonably rely without taking specific advice.
In particular, it should not be considered
financial product advice for the purposes of the
Corporations Act 2001.
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